Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Les Hôtels de Paris SA (EPA:HDP) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Les Hôtels de Paris Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Les Hôtels de Paris had €95.2m of debt, an increase on €72.7m, over one year. However, it also had €6.03m in cash, and so its net debt is €89.1m.
How Healthy Is Les Hôtels de Paris’s Balance Sheet?
According to the last reported balance sheet, Les Hôtels de Paris had liabilities of €40.1m due within 12 months, and liabilities of €127.4m due beyond 12 months. Offsetting this, it had €6.03m in cash and €9.45m in receivables that were due within 12 months. So its liabilities total €152.0m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the €20.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. After all, Les Hôtels de Paris would likely require a major re-capitalisation if it had to pay its creditors today.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.29 times and a disturbingly high net debt to EBITDA ratio of 12.5 hit our confidence in Les Hôtels de Paris like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. One redeeming factor for Les Hôtels de Paris is that it turned last year’s EBIT loss into a gain of €3.1m, over the last twelve months. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Les Hôtels de Paris will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Looking at the most recent year, Les Hôtels de Paris recorded free cash flow of 32% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Les Hôtels de Paris’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn’t such a worry. After considering the datapoints discussed, we think Les Hôtels de Paris has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We’ve identified 4 warning signs with Les Hôtels de Paris (at least 1 which is significant) , and understanding them should be part of your investment process.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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